Long-Term Outlook: Slow Growth And Deflation

This
week I am really delighted to be able to give you a condensed version of Gary
Shilling's latest INSIGHT newsletter for your Outside the Box. Each month I
really look forward to getting Gary's latest thoughts on the economy and investing.
Last year in his forecast issue he suggested 13 investment ideas, all of which
were profitable by the end of the year. It is not unusual for Gary to give
us over 75 charts and tables in his monthly letters along with his commentary,
which makes his thinking unusually clear and accessible. Gary was among the
first to point out the problems with the subprime market and predict the housing
and credit crises. You can learn more about his letter at http://www.agaryshilling.com.
If you want to subscribe (for $275), you can call 888-346-7444. Tell them that
you read about it in Outside the Box and you will get not only his recent 2009
forecast issue with the year's investment themes, but an extra issue with his
2010 forecast (of course, that one will not come out for a year. Gary is good
but not that good!) I trust you are enjoying your week. And enjoy this week's
Outside the Box....

And if you have cable and get Fox Business News, I will be on Happy Hour tomorrow
Tuesday the 17th at 5 pm Eastern. Have a great week.

John Mauldin, Editor
Outside the Box

Long-Term Outlook: Slow Growth And Deflation
by Gary Shilling

From 1982 until 2000, the U.S. economy enjoyed rapid growth with real GDP
rising at a 3.6% average annual rate. Furthermore, this 18-year expansion,
which cumulated to an 89% rise in inflation-adjusted economic activity, was
interrupted by only one recession, the relatively mild 1990-1991 downturn,
which depressed real GDP by only 1.3% from peak to trough.

Extended Expansion

From a fundamental standpoint, the growth spurt ended in 2000 as shown by
basic measures of the economy's health. The stock market, that most fundamental
measure of business fitness and sentiment, essentially reached its peak with
the dot com blow-off in 2000 and has been trending down ever since (Chart 1).
The same is true of employment, goods production and household net worth in
relation to disposable (after-tax) income.

Chart 1

Nevertheless, the gigantic policy ease in Washington in response to the stock
market collapse and 9/11 gave the illusion that all was well and that the growth
trend had resumed. The Fed rapidly cut its target rate from 6.5% to 1% and
held it there for 12 months to provide more-than ample monetary stimulus. Meanwhile,
federal tax rebates and repeated tax cuts generated oceans of fiscal stimulus.

As a result, the speculative investment climate spawned by the dot com nonsense
survived. It simply shifted from stocks to housing (Chart 2), commodities,
foreign currencies, emerging market equities and debt, hedge funds and private
equity. Investors still believed they deserved double-digit returns each and
every year, and if stocks no longer did the job, other investment vehicles
would. Thus persisted what we earlier dubbed the Great Disconnect between the
real world of goods and services and the speculative world of financial assets.

Chart 2

Not Sustainable

Even before these final speculative binges, the forces driving the economy
in its long expansion were unsustainable, as we've been stressing for years
in Insight. These forces included the decline in the consumer saving
rate and jump in consumer debt, the vast leveraging of the financial sector,
increasingly freer trade and loose financial regulation, all of which are now
being reversed.

In the 1980s and 1990s, American consumers were more than willing to cut their
saving rate because they believed stock portfolios would continue to grow rapidly
and take care of all their financial needs. Then, when stocks collapsed in
2000-2002, house appreciation (Chart 3) seamlessly took over to continue the
push down the household saving rate from 12% in the early 1980s to zero. Americans
saw their houses as continually-filling piggybanks because, they believed,
home price appreciation would continue indefinitely. They tapped that equity
freely with home equity loans and cash-out refinancing.

Chart 3

The flip side of saving less is borrowing more, as evidenced by the leap in
all consumer debt and debt service, both in relation to disposable (after-tax)
income and relative to assets. In relation to GDP, the cumulative outside financing
of the household as well as the financial sector leaped for three decades,
measuring the immense leveraging in these two areas. Not surprising, amidst
this consumer borrowing and spending binge, consumer spending's share of GDP
leaped from 62% in the early 1980s to 71% at its peak in the second quarter
of 2008 (Chart 4).

Chart 4

The Tide Turns

Now, however, consumers have run out of borrowing power. As of the third quarter
2008, homeowners with mortgages had on average 25% equity in their abodes after
all mortgage debt was removed and that number will probably drop to the 10%-15%
range with the further decline in house prices we are forecasting (Chart 3).
At that bottom, after a 37% peak-to-trough collapse, almost 25 million homeowners,
or nearly half the 51 million with mortgages, will be under water, with their
mortgages bigger than their house values. In total, the gap will be about $1
trillion.

The nosedive in stocks has also discouraged consumer spending as have mounting
layoffs (Chart 5), maxed out credit cards and tighter lending standards and
weak consumer confidence. Rising medical costs are also a drag on consumers
as their co-pays and deductibles mount. For decades, credit card issuers and
other lenders encouraged consumers to indulge in instant gratification. Buy
now, pay later. But now, habits are changing. Debit cards are becoming popular
since they deduct charges directly from the user's checking account and, therefore,
don't increase indebtedness. Layaway plans are back in style after nearly disappearing.

Chart 5

Financially Unprepared

Between low saving levels in recent years and weak stock prices, few Americans
are prepared financially for retirement. About 54% of 401(k) assets are invested
in stocks, which fell 39% last year as measured by the S&P 500 index. And
except for Treasurys, almost all other investments suffered huge losses in
2008. Around 50 million Americans have 401(k) plans, with $2.5 trillion in
assets, and in the 12 months after the stock market peak in October 2007, over
$1 trillion in stock value was wiped out in 401(k)s and other defined contribution
plans. Another $1 trillion in IRAs was lost.

After 401(k)s were initiated in 1978, those containing stock assets appreciated
in the long 1982-2000 bull market, which convinced many that they didn't need
to save, as mentioned earlier. In 1983, 33% of working-age households were
financially unprepared for retirement, but the number rose to 40% in 1998 as
a result of lower saving and more borrowing, and to 44% in 2006 as the 2000-2002
bear market also depressed retirement funds. Obviously, with the subsequent
collapse in house and stock prices, many more -- over 50% -- are unprepared.
In 2007, in defined contribution accounts administered by Vanguard, the median
account balance for 55-64 year-olds was just $60,740 and only 10% of participants
contributed the maximum amount.

Economic Effects

As households increase their saving rate, their spending growth will slow,
a distinct contrast from the decline of the saving rate from 12% in the early
1980s to zero recently. That decline, which averaged about a half-percentage
point per year, meant that consumer spending grew an average of around a half-percentage
point faster than disposable income annually. For the next decade, we're forecasting
a one percentage point rise in the saving rate annually. That still would not
return it to the early 1980s level of 12% even though the demographics for
saving have gone from the worst to the best in the interim. Applying a 1.5
multiplier to account for the total destimulating effects as those dollars
are saved, not spent, this means a reduction of about one percentage point
in real GDP growth, from 3.6% per annum in the 1982-2000 years to 2.6%.

Although the stock bulls may salivate over the prospect that increased saving
will mean more equity purchases, we believe that most of the money will go
to debt repayment--the flip side of a saving spree. Note that if the saving
rate rises one percentage point per year for 10 years, the cumulative increase
in saving will total about $5.5 trillion. That will go a long way in offsetting
federal deficits and debt.

So will the deflation that we'll explore later. Incomes may grow on average
in real or inflation-adjusted terms, but shrink in current dollars. But debts
are denominated in current dollars and therefore will grow in relation to incomes
and the ability to service them. This will be the reverse of inflation, which
reduced the value of debts in real terms and makes it easier to service them
as incomes rise with inflation.

Foreign Effects

The effects, then, of a consumer switch from a 25-year borrowing-and-spending
binge to a saving spree will be profound for the U.S. economy. Even more so
for the foreign economies that have depended for growth on American consumers
to buy the excess goods and services for which they have no other ready markets.

In 2007, U.S. consumers accounted for 18.2% of global GDP, and that share
has jumped from 14.9% in 1980 and 16.8% in 1990. Furthermore, the shares of
American consumer spending on durable and nondurable goods accounted for by
imports from Central and South America and from the Pacific Rim have leaped
since the early 1990s.

A clear result of the upward trend in consumers' share of GDP (Chart 4) and
declining saving rate for a quarter-century has been the downtrend in the foreign
trade and current account balances. We can't overemphasize the importance of
the profligate U.S. consumer in fueling economic growth in the rest of the
world, as we've discussed in many past Insights. We have also published
our analysis of Asian exports. The intra-Asian trade was much bigger than the
direct exports to the U.S., but when we accounted for the components produced
in, say, Taiwan that were sent for subassembly to Thailand, then to Malaysia
for final assembly with the finished product destined for the U.S., over half
of Asian exports ended up in America.

Export-Dependent China

In late 2007, most forecasters disagreed with us and said China's economy
would continue to grow at double-digit rates, and even support the U.S. economy
if it softened. However, in "The Chinese Middle Class: 110 Million Is Not Enough" (Nov.
2007 Insight), we explained that China was not yet far enough along
the road to industrialization to have a big enough middle class of free spenders
to sustain economic growth if exports fell with U.S. consumer spending, as
we were predicting.

As we noted in that report, in China, it takes $5,000 or more in per capita
income to have meaningful discretionary spending. The 110 million who fit that
category are a lot of people, but only 8% of China's population. In India,
the middle and upper income classes are even smaller, 5%. In contrast, in the
U.S. it takes $26,000 or more to have middle-class spending power, and 80%
of Americans qualify. So we wrote in that report that all the cell phones and
PCs being bought by Chinese was not the result of domestic economic strength,
but merely the recycling of export revenues and direct foreign investment funds.
And we went on to forecast that U.S. consumers would retrench, resulting in
a nosedive in Chinese exports and a deep recessionary slump in China's growth.

Well, as they say, the rest is history. It now seems likely that China's earlier
double-digit growth rates will slip to the 5%-6% range that would probably
constitute a major recession, and probably lower. About 8% growth is needed
to accommodate the vast numbers who continually flood from the countryside
to the cities in search of work and better lives. Of those who went back to
their villages to celebrate the recent lunar new year, 20 million didn't return
because their factory jobs had vanished along with Chinese exports. Worker
unrest us mounting and just as civil disturbances have ended many past Chinese
dynasties, the Mao Dynasty's days may be numbered, as we've discussed in past Insights.

No Winners

With subdued U.S. consumer spending in the years ahead and the resulting weakness
in American imports, economic growth abroad will be even weaker than in the
U.S. Note that in previous U.S. recessions, the current account and trade balances
tend to rise as imports weaken with economic activity, but exports fall less
as economic growth abroad persists. That's been true of late, even though most
would prefer strengthening balances from strong U.S. exports, not weaker imports.
In any event, falling economies overseas are already weakening U.S. exports
(Chart 6) and subdued global growth in the years ahead will probably limit
the improvement in the U.S. current account and trade balances. Notice the
close link between world industrial production and merchandise exports (Chart
7).

Chart 6

Chart 7

First And Last Resort

Now, with American consumers embarking on a saving spree, the U.S. will no
longer be the buyer of first and last resort for the globe's excess goods and
services. Furthermore, with slower global growth for years ahead, virtually
every country will promote exports to spur domestic activity. Already, China
has stopped allowing her yuan to rise in order to gain a bigger share of a
declining pool of global exports.

Financial Deleveraging

There's no question that the financial sector is deleveraging, and its embarrassed
leaders, pressured by regulators and everyone else, will no doubt continue
this process for years to come. Securitization, off-balance sheet financing,
derivatives and other financial vehicles that both stimulated and distorted
economic activity are disappearing.

Big banks are reducing exposure to volatile proprietary trading and emphasizing
safer asset management. Hence, Morgan Stanley's interest in buying Smith Barney,
the brokerage unit of cash-hungry Citigroup. Furthermore, banks are cutting
their financing of hedge funds by concentrating on the likely survivors in
the ongoing shake-out and cutting off the rest. This will hasten the demise
of many less-successful as well as smaller shops that are also at risk of investor
withdrawals.

Banks are retrenching from lending to the point that corporate borrowers are
turning to the bond market instead for funding. Despite government bailouts,
writedowns continue to erode bank capital. Many still hold some of the leveraged
loans they made to fund private equity leveraged buyouts back in the boom days.
Lenders normally recover 80% on those loans when borrowers default since they
rank high in the recovery pecking order. But recent bankruptcies indicate 25%
recovery rates. Earlier, Japanese banks were flush with cash, but sharply lower
earnings outlooks suggest they no longer will be able to provide capital to
international markets.

As banks retreat to their core competencies, they're selling non-essential
units. Faced with lasting fear spawned by huge losses and pressed by regulators,
these institutions are retreating to basic banking 101. That's spread lending
in which deposits are lent with a market-determined interest rate spread that
covers costs plus a modest profit. Banks are also consolidating in response
to gigantic losses and bleak outlooks. France's BNP Paribas bought the Belgium
and Luxembourg assets of Fortis. Spain's Santander is acquiring full control
of Sovereign Bancorp based in Wyomissing, Pa. Large consolidated financial
institutions don't tend to be big risk-takers, and often lack the entrepreneurial
spirit that promotes productivity and economic growth. Also, with fewer institutions,
there are fewer counterparts to share risks, and that also dampens activity.

Eastern Europe

Overseas, Western banks largely financed the rapid economic growth in the
former Iron Curtain countries in Europe after the Soviet Union collapsed in
1991. In addition, many companies in those lands financed their domestic businesses
by borrowing Swiss francs, euros and other hard currencies at lower rates than
in their own inflation-prone countries. Individuals entered the same carry
trade to fund their home mortgages.

Now, however, lenders are retreating as they delever. Exports to Western Europe,
another important source of growth, are falling. Eastern European borrowers
need to repay $400 billion owed to Western banks this year, much of it denominated
in foreign currencies. Eurozone banks have outstanding loans to Central and
Eastern Europe totaling $1.3 trillion. EU leaders, led by German Chancellor
Merkel, recently rejected a $240 billion bailout of Eastern Europe proposed
by Hungary.

Like Asia 1997-1998

The dependence of Central and Eastern Europe on foreign financing is painfully
similar to that is Asia in the 1990s that led to the 1997-1998 financial and
economic collapse--except it probably will be worse this time since banks are
delevering this time and weren't back then. Also, these European countries
were more leveraged in 2008 than their Asian counterparts a decade ago. This
can be seen in their foreign debts in relation to GDP (Chart 8) and in their
current account deficit/GDP (Chart 9) as well as in their currency declines.

Chart 8

Chart 9

Asian lands reacted to the 1997-1998 crisis by cutting foreign borrowing and
building foreign currency reserves. Ironically, however, they still didn't
escape the current global recession and financial crisis. They're no longer
as dependent on inflows of foreign capital, but this time are highly dependent
on exports, which are plummeting as U.S. consumers retrench.

Commodity Crisis

The collapse of the commodity bubble will also subdue global economic growth
in future years. Sure, commodity consumers benefit from lower prices as producers
lose. But the share of total spending on commodity imports by consumers, especially
developed lands, is tiny while they account for the bulk of exports for producers,
notably developing countries.

Budget Signals

The new Obama federal budget points clearly to more government regulation
and involvement in the economy. Going well beyond dealing with the deepening
recession and financial crisis, the President wants $630 billion to move toward
national health insurance. Businesses that emit carbon dioxide and other greenhouse
gases would have to purchase permits. Another $20 billion would go for clean
energy technology. The government would essentially take over student loans
while eliminating private lenders, and make them entitlements with no annual
limits on loan totals.

Obama also plans to increase taxes in higher-income households and capital
gains and estate while redistributing money to lower-income people, even those
who don't pay taxes. This reflects his populist views on the campaign trail,
but with considerably more edge. The President's budget document states, "Prudent
investments in education, clean energy, health care and infrastructure were
sacrificed for huge tax cuts for the wealthy and well-connected. In the face
of these trade-offs, Washington has ignored the squeeze on middle-class families
that is making it harder for them to get ahead. There's nothing wrong with
making money, but there is something wrong when we allow the playing field
to be tilted so far in the favor of so few." The President's budget message
also attacks "a legacy of misplaced priorities...and irresponsible policy choice
in Washington."

Corporations, the energy industry, hedge funds and large farmers would also
pay higher taxes while families with annual incomes under $200,000 and especially
the working poor would get government checks.

The budget calls for more enforcement money for the FDA to step up drug safety
rules, more for the EPA to crack down on industrial polluters, additional funds
to protect endangered species and land and water conservation and to protect
wildlife from climate change. More money is also requested to enforce fair
housing laws and better disclosure of mortgage terms and to reverse "years
of erosion in funding for labor law enforcement agencies." Employers that don't
offer retirement plans will be forced to open IRAs for employees. There's also
additional funds requested for enforcing workplace safety rules.

Stress Tests

Major banks are being stress-tested to determine their volatility under adverse
conditions. To date, Fannie and Freddie are in conservatorship and controlled
by the government. The remaining major investment banks, Goldman Sachs and
Morgan Stanley are bank holding companies with Federal Reserve regulation.
Is it a big surprise that Litton Loan Servicing, owned by Goldman, recently
changed its strategy on mortgage modification to reduce borrowers' monthly
payments to 31% of income from 38%, the industry standard?

Citigroup and BofA are, for all intents and purposes, wards of the state while
the media and Washington spar over whether they will be formally owned by the
government. Those two banks recently agreed to suspend mortgage foreclosures
until the Treasury sets up its rescue program.

AIG is 85% owned by the Fed, which probably wishes it owned nothing of that
bottomless money pit that has already absorbed $150 billion in government money.
Recently, the government initiated its fourth plan to rescue AIG,which just
reported a $62 billion loss in the fourth quarter. The firm is so troubled
that Washington has completely backed away from its role as a stern lender
that forced AIG to pay high interest rates on what it assumed would be short-term
loans. Now the government is relaxing loan terms by wiping out interest in
hopes of preserving some value for AIG. And it will be more involved as it
splits AIG into two pieces and gets preferred shares in each entity.

Auto Bailout Payback

Beyond the financial sector, the ongoing bailout of U.S. auto producers is
leading to more government intervention in that industry. As usual, he who
pays the piper calls the tune. The government has already pumped $17.4 billion
into GM and Chrysler, and they say they may need $21.6 billion more. GM also
proposes a $4.5 billion credit insurance program for the auto parts makers.
Furthermore, GMAC may need more than the $5 billion sunk into it by the Treasury
last December.

Bonuses

Of all the signs of opulence carried over from the bubble years, corporate
jets and big executive bonuses seem to bother Washington the most. BofA is
selling three of its seven jets, a helicopter that was owned by Merrill Lynch
and one of two of its New York corporate apartments. Obama wants firms that
accept "extraordinary assistance" from the government to cap annual pay at
$500,000, disclose pay to shareholders for a non-binding vote, claw back bonuses
of corporate officials who provide misleading information, eliminate golden
parachutes for those terminated and adopt board policies for luxuries such
as entertainment and jets.

This reaction to big bonuses in firms that are taking huge writeoffs, losing
big money and requiring massive government bailouts was predictable. From 2002
to 2008, the five largest Wall Street firms paid $190 billion in bonuses while
earning $76 billion in profits. Last year, they had a combined net loss of
$25 billion but paid bonuses of $26 billion.

The Trouble With More Regulation

Increased regulation may be the natural reaction to financial and economic
woes, but it is fraught with problems. It's a reaction to crises and, therefore,
comes too late to prevent them. And it often amounts to fighting the last war
since the next set of problems will be outside the purview of these new regulations.
That's almost guaranteed to be the case since fixed rules only invite all those
well-paid bright guys and gals on Wall Street and elsewhere to figure ways
around them.

Furthermore, government regulators have never, as far as we know, stopped
big bubbles or caught big crooks. Consider the dot com and then the housing
blowoffs, both of which occurred while the SEC, the Fed, other regulators,
Congress, etc. sat on their hands. Think about Enron, WorldCom and Bernie Madoff,
all of whom went on their merry ways until their self-induced collapses, completely
free of regulatory interference.

Most importantly, government regulation and involvement in the economy is
almost certain to prove inefficient. Risk-taking has been excessive, but government
bureaucrats are likely to eliminate much of it, to the detriment of entrepreneurial
activity, financial innovation and economic growth. Fannie, Freddie and government-controlled
banks are now being directed by the government to modify mortgages to accommodate
distressed homeowners. That may implement government policy, but leads to bad
business decisions.

Confusion

Furthermore, if financial regulation changes massively, it probably will create
confusion and uncertainty to the detriment of adequate financing, spending
and investment. Some academics believe that the Great Depression was prolonged
because the New Deal measures were so disruptive that banks and other financial
firms as well as individual investors, consumers and businessmen were too scared
to do anything. Recently, Tadao Noda, a Bank of Japan policy board member,
said, "We are in a position where the central bank needs to interfere in financial
markets, but if we do too much, the market functioning in turn may be hurt." In
any event, major problems inexorably lead to greater government involvement.
The Bush Administration was staunchly deregulatory in philosophy but forced
to intervene in the financial crisis. The 20th century saw tremendous growth
in government involvement in all aspects of the economy and financial markets
as a result of three tremendous traumas--World Wars I and II and the Great
Depression.

Protectionism

Recessions spawn economic nationalism, protectionism, and the deeper the slump,
the stronger are those tendencies. It's ever so easy to blame foreigners for
domestic woes and take actions to protect the home turf while repelling the
invaders. The beneficial effects of free trade are considerable but diffuse
while the loss of one's job to imports is very specific. And politicians find
protectionism to be a convenient vote-getter since foreigners don't vote in
domestic elections.

U.S. Leadership

Sadly, the U.S. appears to be among the leaders for protection of goods and
services against foreign competition. The auto loan program last year under
the Bush Administration largely excluded foreign transplants. Obama advocates
a super-competitive economy, which requires highly productive workers. Yet
the recent fiscal stimulus law restricted H-1B visas, granted to foreigners
with advanced education and skills, for employees of firms that receive TARP
(bank bailout) money.

Some in Congress worried that tax credits for renewable energy should be confined
to American-produced equipment. And recall that during the presidential campaign,
Obama called for renegotiating the North American Free Trade Agreement. Furthermore,
the President's emphasis on health care, education and renewable energy turns
attention inward, toward self-sufficiency and away from a global focus.

Outside the U.S., protectionism is being promoted by labor unrest. In England,
workers at a French-owned oil refinery struck because Total awarded a construction
contract to an Italian firm that planned to use its own staff from abroad rather
than local workers. Rioters on the French Caribbean island of Guadeloupe protested
high prices for food and other necessities for a month recently. High unemployment
rates, especially among younger workers, have precipitated riots in Latvia,
Lithuania, Greece, Russia and Bulgaria as well as France.

Competitive Devaluations

Good old-fashioned competitive devaluations to spur exports and retard imports,
a mainstay of the 1930s, are making a comeback. Kazakhstan recently devalued,
in part because of devaluations of her trading partners. As noted earlier,
China stopped allowing her yuan to appreciate, in part because her labor costs
are being undercut by countries like Vietnam and Bangladesh.

With the understanding that protectionism helped make the Great Depression "Great," country
leaders still publicly espouse free trade and reject protectionism. And they
express confidence that global organizations like the WTO, IMF and World Bank
will forestall protectionism and economic nationalism, and they engage in endless
meetings to promote free trade as well as global standards and cooperation
for handling the deepening financial crisis. But almost nothing happens, as
shown by the recent EU refusal to bail out Eastern Europe.

Stealth Protectionism

In any event, protectionism is returning by stealth. U.S. steelmakers plan
to file anti-dumping suits against foreign producers, a strategy they have
employed successfully for decades, and India recently proposed increased steel
tariffs. In the first half of 2008, WTO antidumping investigations were up
30% from a year earlier. Bank bailouts have been aimed at protecting local
institutions, as discussed earlier, and the Japanese government is buying stocks
of Japan-based corporations to help company balance sheets, but also giving
them a competitive advantage over the subsidiaries of foreign outfits.

Like America, France is aiding its own auto producers, not transplants, and
has created a sovereign wealth fund to keep "national champions" out of foreign
ownership. Since last November, Russia has introduced 28 import duty and export
subsidies affecting steel, oil and other products as well as imposed special
road tolls on trucks from the EU, Switzerland and Turkmenistan. Russia's tariff
on imported cars recently rose 5 to 10 percentage points, curtailing shipments
of used cars from Japan to the Russian Far East.

Meanwhile, Argentina has imposed new obstacles to imported shoes and auto
parts. The EU again is giving export refunds to dairy farmers, to the detriment
of New Zealand, slapped anti-dumping charges on Chinese nuts and bolts, and
threatens duties on U.S. biodiesel imports in retaliation for America's export
subsidies. Not to be outdone, the U.S. plans retaliatory tariffs on Italian
water and French cheese in reaction to EU restrictions on U.S. chicken and
beef imports in the hormones war.

Ecuador lifted tariffs across the board recently, with the levy on imported
meat rising to 85.5% from 25%. Indonesia is using special import licenses to
limit the inflow of clothing, shoes and electronics and also is curtailing
toy imports by allowing them to enter through only a few of its ports. And
there's the old standby, health and safety standards that Japan relies on consistently
to keep out unwanted products.

Deflation

Long-time Insight readers know that we have been forecasting chronic
deflation to start with the next major global recession. Well, that recession
is here. As discussed in our Nov. 2008 Insight, deflation results when
the overall supply of goods and services exceeds demand, and can result from
supply leaping or from demand dropping. We've been forecasting chronic good
deflation of excess supply because of today's convergence of many significant
productivity-soaked technologies such as semiconductors, computers, the Internet,
telecom and biotech that should hype output. Ditto for the globalization of
production and the other deflationary forces we've been discussing since we
wrote two books on deflation in the late 1990s, Deflation: Why it's coming,
whether it's good or bad, and how it will affect your investments, business
and personal affairs (1998) and Deflation: How to survive and thrive
in the coming wave of deflation (1999). As a result of rapid productivity
growth, fewer and fewer man-hours are needed to produce goods and services.
Estimates are that 65% of jobs lost in manufacturing between 2000 and 2006
were due to productivity growth with only 35% due to outsourcing overseas.

Similar conditions held in the late 1800s when the American Industrial Revolution
came into full flower after the Civil War. Value added in manufacturing leaped,
and at the same time, real GNP grew 4.32% per year from 1869 to 1898, an unrivaled
rate for a period that long, and consumption per consumer jumped 2.33% per
year. Yet wholesale prices dropped 50% between 1870 and 1896, a 2.6% annual
rate of decline. Good deflation also existed in the Roaring '20s when the driving
new technologies were electrification of factories and homes and mass-produced
automobiles.

The 1930s

In contrast, bad deflation reigned in the 1930s as the Great Depression pushed
demand well below supply. As in the 1839-1843 depression, the money supply,
prices, banks and real goods and services all nosedived. Employment dropped
along with prices in the Great Depression and the unemployment rate rose to
25%. That depression was truly global.

We've consistently predicted the good deflation of excess supply, but in our
two Deflation books and subsequent reports, we said clearly that the
bad deflation of deficient demand could occur--due to severe and widespread
financial crises or due to global protectionism. Both are clear threats, as
explained earlier in this report.

Furthermore, with slower global economic growth in the years ahead due to
the U.S. consumer saving spree, worldwide financial deleveragings, low commodity
prices, increased government regulation and protectionism, excess global capacity
will probably be a chronic problem. So deflation in the years ahead is likely
to be a combination of good and bad.

Supply will be ample due to new tech, globalization and other factors we've
explored over the years such as no big global wars (we hope), continual inflation
worries by central bankers, continuing restructuring, and cost-cutting mass
retailing. But demand will be weak, as discussed earlier. The chronic 1% to
2% deflation from excess supply that we forecast earlier still seems likely,
but now we're adding 1% due to weak demand for a total of 2% to 3% annual declines
in aggregate price indices for years to come.

2009 Seems Easy

For four reasons, the deflation that started several months ago (Chart 10)
is quite likely to persist along with the recession, or at least until early
2010. First, the collapse in commodity prices continues and past declines are
still working their way through the system. Crude oil prices have collapsed
from $147 per barrel to around $40. Steel semi-finished billet prices were
$1,200 a metric ton last summer but now is $350. Iron ore costs per metric
ton dropped from $200 early last year to $80. It takes time for steel prices
to work through to final consumer goods prices such as for washing machines.

Chart 10

Second, producers, importers, wholesalers and retailers were caught flat-footed
by the sudden nosedive in consumer spending late last year and continue to
unload surplus goods by slashing prices. All the giveaway bargains at Christmas
still didn't entice enough consumers to open their wallets. Spring apparel,
ordered before consumer retrenchment, is clearly in excess and being marked
down before it's put on the racks. Retailers from Saks on down continue to
chop prices. Branded food product manufacturers are willing to promote their
wares alongside the private-label goods that supermarkets shoppers increasingly
favor.

Wage Cuts

Third, wages are actually being cut for the first time since the 1930s. Previously,
labor costs were controlled by layoffs, which still dominate. Benefits have
also been trimmed in recent years by switching from defined contribution pensions
to 401(k)s and increasing employee contributions to health care costs. Most
workers are less sensitive to benefits than to salaries and wages, but the
deepening recession and mounting layoffs (Chart 5) are making them more amenable
to wage cuts.

So is the growing use of this approach. In a recent poll, 13% of companies
plan layoffs in the next 12 months, but 4% expect to reduce salaries and 8%
will cut workweeks.

So it just isn't the CEO who is taking the symbolic pay cut to deal with tough
times. We argued in our Deflation books that cutting pay rather than
staff is more humane, better for morale and better for keeping the organization
together and ready for a business rebound. Now increasing numbers of employers
agree with us.

A final reason to expect deflation in coming quarters in the U.S. is the surplus
of aggregate supply over demand. Notice that the supply-demand gap is an excellent
forerunner of inflation six months later. And deflation this year is spreading
globally. Japan is once again flirting with falling prices, Thailand's CPI
in January fell year over year for the first time in a decade. In Europe, inflation
rates are rapidly approaching zero.

Prices In Recovery

The real test of deflation will come when the economy recovers--in early 2010
or later, we believe. Inflation rates normally fall in recessions, but then
revive when the economy resumes growth. This time, inflation rates started
low, so declines into negative territory are normal, especially given the severity
of the recession and the collapse in energy and other commodity prices. If
we're right, however, aggregate price indices like the CPI and PPI will continue
to drop in economic recovery and verify the arrival of chronic deflation.

Few agree with us. They've never seen anything but inflation in their business
careers or lifetimes, so they think that's the way God made the world. Few
can remember much about the 1930s, the last time deflation reigned. Furthermore,
we all tend to have inflation biases. When we pay higher prices, it's because
of the inflation devil, but lower prices are a result of our smart shopping
and bargaining skills. Furthermore, we don't calculate the quality-adjusted
price declines that result from technological improvements. This is especially
true since many of those items, like TVs, are bought so infrequently that we
have no idea what we paid for the last one. But we sure remember the cost of
gasoline on the last fill-up a week ago.

Too Much Money?

The main reason most expect inflation to resume, however, is because of all
the money that's being pumped out by the Fed and other central banks as well
as the Treasury to finance the mushrooming federal deficit. When the economy
revives, they fear, all this liquidity will turn into inflationary excess demand.

At present, the Fed's generosity isn't getting outside the banks into loans
that create money.

When cyclical economic recovery finally does arrive in 2010 or later, it will
probably be sluggish and lenders will still likely be cautious, as discussed
earlier. Furthermore, any meaningful increase in loans will probably continue
to be more than offset by the continual destruction of liquidity as writedowns,
chargeoffs, elimination of derivatives, etc. persists for years. Derivatives
represent liquidity. You can't use them at the grocery store, but at least
until recently, they were interchangeable from money in many uses.

In Sum

The deepening recession and spreading financial crisis is the beginning of
the unwinding of about three decades of financial leverage and spending excesses.
The process will probably take many years to complete as U.S. consumers mount
a decade-long saving spree, the world's financial institutions delever, commodity
prices remain weak, government regulation intensifies and protectionism threatens,
if not dominates. Sluggish economic growth and deflation are the likely results.

Note: John Mauldin is president of Millennium Wave Advisors, LLC, (MWA)
a registered investment advisor. All material presented herein is believed
to be reliable but we cannot attest to its accuracy. Investment recommendations
may change and readers are urged to check with their investment counselors
before making any investment decisions. Opinions expressed in these reports
may change without prior notice. John Mauldin and/or the staff at Millennium
Wave Advisors, LLC may or may not have investments in any funds cited above.
Mauldin can be reached at 800-829-7273. MWA is also a Commodity Pool Operator
(CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well
as an Introducing Broker (IB). John Mauldin is a registered representative
of Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer.
Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Funds recommended
by Mauldin may pay a portion of their fees to Altegris Investments who will
share 1/3 of those fees with MWS and thus to Mauldin. For more information
please see "How does it work" at www.accreditedinvestor.ws.
This website and any views expressed herein are provided for information purposes
only and should not be construed in any way as an offer, an endorsement or
inducement to invest with any CTA, fund or program mentioned. Before seeking
any advisors services or making an investment in a fund, investors must read
and examine thoroughly the respective disclosure document or offering memorandum.
Please read the information under the tab "Hedge Funds: Risks" for further
risks associated with hedge funds.

If you would like to reproduce any of John Mauldin's E-Letters you must include
the source of your quote and an email address (John@FrontlineThoughts.com)
Please write to info@FrontlineThoughts.com
and inform us of any reproductions. Please include where and when the copy
will be reproduced.

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment
advisor. All material presented herein is believed to be reliable but we cannot
attest to its accuracy. Investment recommendations may change and readers are
urged to check with their investment counselors before making any investment
decisions.

Opinions expressed in these reports may change without prior notice. John
Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have
investments in any funds cited above.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS
WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING
ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS
RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND
OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT
LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION
INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN
DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY
REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE
UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT
MANAGER.